5 ‘Whys’ for Commercial Real Estate Investing

On a stand-alone basis, CRE may offer compelling value as a source of current income. Yet its capacity to reduce volatility is enhanced when it is included in a balanced portfolio. Like stocks and bonds, real estate is influenced by economic and financial drivers, such as economic output and interest rates. But it also has unique characteristics, including extended lease terms, sensitivity to development activity (currently near an all-time low), and other factors. Correlation coefficients are used to compare risk and the similarity of risks between asset classes. Accordingly, the return correlations of CRE with other asset classes have historically been low (see Figure 1.6).

The fact that CRE has a low correlation with stocks implies that a crisis in equity markets would not likely affect real estate proportionately, limiting the overall damage to a portfolio containing both investments. With correlations of less than 0.25 to all major asset classes, CRE has meaningful capacity to reduce portfolio volatility through diversification.

[Practice Pointer: If your clients are heavily weighted in a portfolio of publicly traded stocks or equities, investing in CRE will reduce their risk exposure and help reduce the volatility of the portfolio. As we will see later, this mixed approach will also maximize portfolio returns over the long run.]

Additional diversification can be found within the CRE market through exposure to a broad range of property types, geographies, and tenants.

• Property types: The major CRE property types have unique economic drivers that can impact their performance, including job growth (office), demographics (multifamily), retail sales (retail), business and leisure travel (hotel), and manufacturing and international trade (industrial).
• Geographies: Local CRE markets behave differently due to structural factors (e.g., physical or regulatory barriers to new supply) or economic drivers (e.g., a significant presence of specific industries, such as energy, technology, finance, or government).
• Tenants: The selection of tenants making rental payments and the industries they compete in allow for additional diversification. Over economic cycles, government or healthcare tenants may prove more resilient in recessions, but they can be more vulnerable to policy risks. Finance, technology, and other companies may be sensitive to factors transcending the broader economy (e.g., global oil prices, financial regulation, and business capital spending).

Inflation Hedging

Inflation is currently modest, in line with the Federal Reserve's implicit target of around 2%, and elevated levels of unemployment will likely keep inflation fears at bay for the time being. However, the Fed's rampant money printing (its balance sheet has more than tripled since the financial crisis of 2008 to more than $3 trillion) has raised the possibility of a significant upturn in inflation once economic conditions firm.

CRE can help to mitigate inflation risks. Fundamentally, the value of real estate is supported by the rental payments it generates. In periods of high inflation, rising wages and profits increase the nominal amount tenants are willing to pay for any given amount of space. Meanwhile, higher construction costs (due to rising labor rates and commodity prices) restrict commercial development. The resulting increase in demand and decrease in supply lift rental rates and cash flows. Even if rents do not respond immediately, inflation-fearing investors typically price future rent increases into current values. Over the long term, CRE prices tend to rise with replacement costs, which are driven by inflation.

Several academic studies have confirmed CRE's ability to hedge inflation. Although many of these studies are statistically complex, at the most basic level CRE has exhibited a strong correlation with inflation relative to other investments (Figure 1.7). It certainly proved its worth during the United States' last major inflation scare, following the oil crisis of the 1970s. From 1979 to 1982, as consumer prices increased 10% per year, CRE delivered strong returns averaging 14%, while stocks (9%) and bonds (6%) lost ground on an inflation-adjusted basis.

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